Capital Budgeting and

Cost Analysis

2

Two Dimensions of Cost Analysis

period-by-period dimension

project-by-project dimension

Capital budgeting deals with the project-by project dimension

Projects are analyzed over their entire life span

Analysis is typically based on cash flows

3

Stages of Capital Budgeting

Stage 1: Identification Stage• Which types of investments are necessary?

Stage 2: Search Stage• Explore alternative investments

Stage 3: Information Acquisition Stage• Consider costs and benefits

Stage 4: Selection Stage• Choose projects to be implemented

Stage 5: Financing Stage• Obtain necessary funding

Stage 6: Implementation and Control Stage• Implement projects and monitor performance

4

Capital Budgeting Methods

Net Present Value (NPV)Internal Rate of Return (IRR)PaybackAccrual Accounting Rate of Return (AARR)

NPV and IRR are Discounted Cash Flow (DCF) Methods• Analysis is based on Cash Flows • Time Value of money is taken into consideration

5

Investment Project- Replacement decision

Old Machine• Useful life: 3 years• Depreciation per period: 10,000• Book value: 30,000• Cash flow from disposing old machine (after tax): 12,000

New Machine:• Useful life: 3 years• Cost: 210,000• Additional working capital needs: 10,000• Depreciation per period: 70,000• Cost savings per period: 90,000 (after tax)• Estimated terminal disposal value: 0

Applied Discount Rate: 0.10

6

Net Present Value method

Decision Rule: Replace the old machine if the NPV of the replacement is positive:

NPV is consistent in the sense that the NPV is positive if and only if the investment increases the firm valueProblems occur when NPV is used to compare projects with different useful lifes !!!!

83.329,231.1000,100

1.1000,90

1.1000,90000,208 32 =+++−=NPV

7

Example- Second Option

New Machine:• Useful life: 6 years• Cost: 372000• Additional working capital needs: 10,000• Depreciation per period: 62,000• Cost savings per period: 90,000• Estimated terminal disposal value: 0

Does that mean option 2 is preferable???

2.618,271.1000,100...

1.1000,90000,370 6 =+++−=NPV

09.842,311.1000,100...

1.1000,120

1.1000,90

1.1000,90000,20812 632 =−++−=⋅NPV

8

Annuity

Definition: An Annuity is the constant payment that can be received from an investment project with some given NPV The annuity of a project with positive (negative) NPV is always positive (negative)• A project with positive annuity increases firm value

Annuity:

Replacement example: Annuity of net cash savings1)1(

)1(−+

+= n

n

rrrNPVAn

27.381,911.11.11.083.329,23 3

3=

−⋅

=An 83.329,23)( =savingscashNPV

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Internal Rate of Return

IRR is the discount rate that makes NPV=0

IRR=16.15%Easy calculations only in special cases: • CF are constant and useful life n=> ¶• CF are constant and useful life is n=2

Decision rule: Choose replacement if IRR> RRR=0.1If the alternative is to either replace the old machine or to keep it (do nothing), IRR-Method and NPV-Method lead to identical decisions

32 )1(000,100

)1(000,90

1000,90000,2080

IRRIRRIRRNPV

++

++

++−==

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Problems with IRR

Choice of alternative projects:

IRR-Method leads to sub-optimal decision!!There can be more than one IRR if some of the CF are negativeThere might be only a complex IRR

34.908,111.1000,45

1.1000,45

1.1000,45000,1002 32 =+++−=NPV

83.329,231=NPV

%65.162 =IRR%15.161=IRR

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Payback Method

Measures the time it will take to recoup the initial investment in a projectUniform Cash Flows

Highlights liquidity issuesReflects increasing uncertainty over timeMain weaknesses:• Does not consider payments after the payback period• Fails to incorporate time value of money

flowcashfutureannual inincreaseUniformInvestment initialNet =periodPayback

12

Payback Method with Nonuniform Cash Flows

Replacement example:

Simplifying assumption: cash savings occur uniformly throughout the final year

Year Cash savings Net Investment unrecovered at year end

0 0 208,000 1 90,000 118,000 2 90,000 28,000

28.2100,00028,0002period =+=Payback

13

Accrual accounting Rate-of-Return Method

Devides an accrual accounting measure of annual average income of a project by an accrual accounting measure of its investment

Replacement example:

InvestmentinitialNet income operating taxafter annual

average expectedinIncrease−=AARR

1442.0208,000

000,60000,90=

−=AARR

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Accrual accounting Rate-of-Return Method

Problems:• Similar to IRR a rate-of-return percentage is calculated• All weaknesses of the IRR persist• In addition time value of money is not considered

Accounting numbers are used rather than cash flows• Easy to get from the accounting system• Due to timing differences in profit and loss recognition versus cash

flows interest effects occur that lead to misspecification• Decisions made based on AARR possibly wrong• If manager’s are evaluated based on accounting profits AARR may

be relevant for investment decisions though it does not maximizefirm value

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Relevant Cash Flows

Which cash flows are relevant in making an investment decision?Relevant cash flows are the differences in expected future cash flows if an investment is madeTwo alternatives:• Estimate future cash flows with and without the investment under

consideration and compare the results• Calculate the differences in a first step and determine the NPV of

these differences

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Replacement Example Continued:

Additional information:• Applicable tax rate is 20%• Operating cash flow savings before tax are 97,500• Tax effects of cash in- and outflows occur at the same time as the

cash flows themselves ( simplifying assumption)

Old machine New machine Purchase price - 210,000 Current book value 30,000 - Current disposal value 7,500 - Terminal disposal value after three more years

0 0

Annual depreciation 10,000 70,000 Working capital required 5,000 15,000

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Relevant After-Tax Flows: Differential Approach

First Step:Determine changes in net income per year from undertaking the replacement:

Income effects are relevant as they determine tax effects!!!

Savings in costs: 97,500 -Additional depreciation: 60,000 Increase in operating income: 37,500 -Income taxes: 7,500 Increase in operating net income: 30,000

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Relevant After-Tax Flows: Differential Approach

Categories of cash flows:Net initial investment• Initial machine investment• Initial working capital investment• After tax cash flow from disposal of old machine

After tax cash flow from operations• Annual after-tax cash flow from operations• Income tax cash savings from annual depreciation deductions

After tax cash flow from terminal disposal• After tax cash flow from terminal disposal of machine• After tax cash flow from terminal recovery of working-capital

investment

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Relevant After-Tax Flows: Differential Approach

t 0 1 2 3 Initial machine investment (210,000) Initial working capital investment (10,000) After tax cash flow from disposal 12,000* Net initial investment (208,000) Annual after tax cash flow from operations

78,000** 78,000 78,000

Income tax savings from additional depreciation

12,000*** 12,000 12,000

After tax cash flow recovering working capital

10,000

Total relevant cash flows (208,000) 90,000 90,000 100,000

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Relevant After-Tax Flows: Differential Approach

* Cash flow from disposal of old machine:• Sales price: 7,500• Tax savings: (7,500-30,000)0.2=4,500• Sales price+Tax savings=12,000

**After tax cash flow from operations:• Cost savings before tax: 97,500• Tax on cost savings:0.2*97,500=19,500• Cost savings after tax: 97,500-19,500=78,000

***Tax savings from additional depreciation:• 0.2*60,000=12,000

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Strategic considerations in Capital Budgeting

A machine replacement is an operating rather than a strategic decisionFinancial aspects drive such decisionsStrategic capital budgeting decisions implement the firm‘s strategy• Whether to invest in a new industry• Whether to invest in a new product line• Whether to invest in new technology

For such decisions a broader range of factors need to be considered and long term effects need to be estimated

22

Pick your Choice

Rusty Pipe is considering a new capital investment. The following information is available on the investment. The cost of the machine will be $150,000. The annual cost savings if the new machine is acquired will be $40,000. The machine will have a 5-year life, at which time the terminal disposal value is expected to be $20,000. Rusty Pipe isassuming no tax consequences. If Rusty Pipe has a required rate of return of 10%, what is the net present value of the project?

$1,604$ 12,418$ 14,050$150,000

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True or False

Managers using deferred cash flow methods to make capital budgeting decisions make the same decisions that they would make in using the accrual accounting rate-of-return methods.

In determining whether to keep a machine or replace it, the original cost of the machine is always a relevant factor.

The accrual accounting rate of return is the method that looks most like the information in the financial statements.